1.25     Query

Valuation of inventories.

1.A public sector company, manufacturing bulk drugs and formulations, is subject to Drugs Price Control Orders. The time taken from the date of introduction of raw materials in the process to the date of obtaining bulk drugs duly tested by the quality control takes about a month. Some quantity is sold in the market and the balance is further processed to manufacture bulk derivatives and formulations. The process time taken for formulations is between one and two months. The formulations are kept in company godown and then transferred to various depots in the country. Thus they remain in stock for 3 to 6 months. After these are sold the realisation of debtors takes a further period of 3 to 9 months depending on whether the material is sold in trade, central purchase organisation or State Government’s hospitals and institutions.

2. The company is following the accounting policy with regard to valuation of finished goods and work-in-progress as follows:

(i) Work-in-progress: At cost or net realisable value of equivalent finished product based on technical estimate, whichever is lower.

(ii) Finished products awaiting processing: At cost or net realisable value of equivalent product based on technical estimate, whichever is lower.

(iii) Finished products: At cost or net realisable value whichever is lower.

3. For the purpose of valuation of closing stocks as above, an annual cost statement is being prepared in which all costs are allocated and average cost of production of each product is worked out. The company has been following this method consistently in the past and the same was accepted by both the statutory and government auditors.

4.The querist has been informed by the Dy. Director of Commercial Audit, Bombay, that the C& A.G. has issued instructions that for the purpose of valuation of closing stocks, the cost should represent –

                        “(a) The cost of purchase;

                        (b) The cost of conversion; and

(c) Other costs incurred in the normal course of business in bringing the inventories to their present location and condition.

The cost of purchase should consist of the purchase price including duties and taxes, freight inward and other expenses directly related to acquisition etc. in respect of such purchases.

The cost of conversion should consist of costs which are specifically attributable to units of production, i.e., direct labor, direct expenses and production overheads.

Costs other than production overheads are sometimes incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. The general administration overheads, research and development cost, selling and distribution expenses, and financial charges should usually be considered as not relating to putting the inventories in their present location and condition and should, therefore, be excluded from the computation of the closing stock.”

5.The querist notes that the instructions given by the C& A.G., as per above, are based on Accounting Standard 2 (AS-2) on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.

6.The querist has informed that the company in question is including research and development cost, general administration overheads and finance charges as elements of cost of production of the products. The querist has submitted that these costs are incurred not only on the finished goods produced and sold but also on the finished stocks produced and lying at the end of the year which is quite substantial. The querist has therefore expressed his view that these costs cannot be ignored while valuing the closing stocks, as explained by the querist in the following paragraphs.

7.The general administrative overheads are salaries and other expenses incurred on administration, accounts, transport etc., and maintenance of branches all over the country. In the view of the querist these costs are necessary for putting the stocks to their present location and condition as per para 28 of AS 2 as these are expenses pertaining to the service departments without which the production department would not be able to produce the stocks.

8.The research and development cost includes, inter alia, maximum expenditure on account of improvement in the processes of the products manufactured and introduction of new products in a pharmaceutical company. The R & D cost is treated as deferred revenue expenditure to be spread over 10 years. The amount of R & D expenditure charged in the accounts as deferred revenue expenditure pertaining to the year is only taken into account to work out the cost of the products manufactured by the company. In view of this, according to the querist, R & D expenditure which actually pertains to improvement in process of products etc., should be treated as cost incurred for putting the inventories in their present location and condition in terms of para 28 of AS 2.

9.With regard to selling and distribution expenses, the querist agrees that the variable selling and distribution expenses should not form part of the cost of production of products but the fixed, i.e., branch maintenance expenses should form part of cost of inventory since they are in the nature of administrative expenditure.

10. Regarding financial charges, the querist has stated that the company is incurring financial charges on account of interest payable on government loans and the interest paid on borrowings from the banks for working capital purposes. The government loans are provided for purchase of fixed assets. These loans are provided in the debt-equity ratio of 1:1. The interest on government loans during construction of assets is capitalised and included in the cost of the assets. The interest charges incurred after the date of capitalisation are a legitimate cost to be included in the cost of production of the products both for sale and stocks maintained in the company. The interest charges incurred on bank borrowings are for holding raw materials, stores and spares, sundry debtors and finished goods inventories. The bank borrowings are as per the bank norms. The querist is of the view that as long as the company is within the norms, the interest charges incurred on bank borrowings should be viewed as cost incurred for putting the inventories in their respective location and condition.

11.The querist has further argued that the nature of the business of the company is such that the sales are mainly to the government hospitals and collections are slow and bank borrowings heavy. It is not possible to produce without incurring heavy interest charges, which is as much a cost of production, according to the querist, as materials and labour. Exclusion of interest from the cost of production shall be most unrealistic as per the querist.

12.In view of the above, according to the querist, inclusion of general administration overheads including fixed selling and other expenses, R & D cost and financial charges for the purpose of valuation of closing stocks would be in order for the following reasons:

(a) The company is following the above method of valuation of inventories consistently from the beginning. This is as per para 31 of AS 2.

(b) The accounting policy of the company regarding valuation of closing stocks has been disclosed in the annual accounts from year to year. This is as per para 30 of AS 2.

(c) As per the querist, the general administrative overheads, R & D cost and financial charges relate to putting the inventories in their present location and condition.

(d) Any change in the accounting policy in this regard will result in showing incomparable figures of opening and closing stocks, in addition to vitiating the profit/loss of the company in the year in which such change is brought about.  

(e) The profit/loss of the company will be overstated/understated if all the above costs are to be treated as period costs as suggested by the C& A.G.

(f) As far as the company in question is concerned, borrowing from the banks is a must without which manufacturing activities cannot be carried on. Thus, finance charges for production activities are inevitable. Though every effort is made to sell the stocks, some remain at the end of the year which are immediately sold in the beginning of the coming year.

(g) Further, the company gets long term orders from DGS & D and Army for which finished goods are to be manufactured well in advance. In this regard the querist has drawn the attention of the Committee to the following recommendation of the Institute of Chartered Accountants, U.K.:

“In businesses which undertake contracts extending over a period of years the normal tendency is to include overhead expenditure in working progress except where it is considered irrevocable.”

(h) Further, in drugs industry, for production of basic drugs and from basic drugs to formulations, the time cycle, from the date of start of manufacturing activity to the date drugs are tested and passed, is more than one month and as such goods produced in the last month of the year, remain in stock at the end of the year.

(i) In the company in question finance charges are inevitable and administrative overheads are such that all the manufacturing departments derive benefit from these activities as without these the manufacturing departments cannot work. In case, finance charges and administrative overheads are excluded from the valuation of stocks, the valuation method cannot be considered to be on facts and the year’s profit and value of closing stocks will not be considered true and faire from year to year.

13. The querist has accordingly sought the opinion of the Expert Advisory Committee as to whether the suggestion of the C & A.G. with regard to valuation of inventories, is applicable to the company.

                                                                                  Opinion                              March 13, 1989

1.The Committee notes that the recommendations made by the C & A.G., which are reproduced in para 4 of the query, are broadly in accordance with AS 2 issued by the Institute of Chartered Accountants of India. The Committee notes, in particular, para 28 of AS 2 which recommends as below:

“Overheads other than production overheads should be included in as part of the inventory cost only to the extent that they clearly relate to putting the inventories to their present location and condition.”

2.The Committee is of the view that inevitability and magnitude of a cost are not the conclusive criteria for deciding that the cost is incurred in putting inventories in their present location and condition. What is essential is that the cost must clearly be incurred and directly related in effecting change in the location and condition of the inventory items. For example, interest cost can be included in the valuation of inventories of timber for the period it is kept in store to enable it to mature so that it could be sold in that condition. In this case there is clearly a change in the condition of the inventory while lying in store. However, if there is no change in condition while an inventory is lying in store the interest cost cannot be included in cost of inventories for the purpose of inventory valuation as per AS 2.

3.The Committee is of the view that in the present case general administrative overheads, R & D cost, fixed element of selling and distribution overheads and finance charges do not clearly relate to putting the inventories in their present location and condition and therefore should not be included in the cost of inventories for the purpose of inventory valuation. The Committee is therefore of the opinion that the suggestion of the C & A.G., with regard to valuation of inventories is applicable to the company.

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